Competition, transparency and quality – the Competition Commission’s final report

On 17 October the Competition Commission (CC) issued its final report on its inquiry into the FTSE 350 audit market.

The CC has decided that:

Audit appointments in respect of FTSE 350 companies should be subject to mandatory re-tendering every 10 years. This is a significant change from their provisional remedy of mandatory re-tendering every 5 years;

The Audit Quality Review (AQR) team should review every audit in the FTSE 350 every 5 years, with the findings and grade to be reported to shareholders;

There should be increased accountability of the auditor to the Audit Committee;

There should be a shareholder advisory vote on the annual Audit Committee Report;

The Financial Reporting Council (FRC) should be given a secondary objective to have due regard to competition; and

So-called “Big 4” clauses in loan agreements should be prohibited.

"This is a sensible outcome. After almost two years and a thorough process, the Competition Commission has put forward a significant package of remedies, including mandatory re-tendering every 10 years, increased accountability of auditors to audit committees, and additional responsibilities for the Financial Reporting Council (FRC). Taken together, these measures will enhance competition, transparency and quality.

The Competition Commission's decision to mandate tendering every 10 years recognises strong concerns from investors, the Financial Reporting Council, companies and the market that a five year interval would have created a disproportionate burden to business, and risked undermining the intensity of competition and audit quality.

The introduction of the FRC's 10 year “comply or explain” regime in October 2012 has had a substantial impact on the market, with 24 FTSE 350 audits put out to tender in the past 12 months and many more expected.

We are pleased that the Competition Commission has ruled out mandatory firm rotation, joint auditing and further restrictions on non-audit services, which would be detrimental to competition and audit quality. However, these debates continue in Europe, where there is uncertainty.

Our focus is to work with investors, companies and regulators to enhance audit quality and ensure the audit is a hallmark for trust in business."

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This short animation illustrates how the UK audit market for large companies works in practice, describing some of the key characteristics of competition in the supply of audits.

View transcript

The UK audit market has been the subject of much comment recently. At first glance it may appear static and the audits of FTSE350 companies overly concentrated. The four largest audit firms dominate, holding relatively stable market shares and companies appear to be passive, tendering and switching audit firm infrequently.

But this isn’t the reality. In fact, there are four simple truths.

Large companies demand large audit firms. Over time, companies have grown, becoming ever-more globalised and sophisticated. Together with increasingly complex international regulation, this makes it important for audit firms to have global reach; deep sector experience and consistent methodologies. As a result, most companies decide that they need a large firm to audit them.

Competition between audit firms is intense as they strive to succeed in a market that is more dynamic than it can first appear. In a market where firms strive for growth, audit appointments are a zero-sum game. Each win is also a loss to a competitor. Indeed, audit firms need to win and retain clients just to maintain market share.

Added to this, the composition of the FTSE350 changes more frequently than you might think. In fact, nearly 700 companies have at some stage been listed in the past 10 years.

Auditors change as well. Over the past decade, FTSE350 companies have decided to switch their auditor more than 130 times. That’s more than one a month.

Companies in the FTSE350 are among the most effective purchasers in the world. Auditors are appointed by shareholders for a period of one year. The process is overseen by experienced and well-informed boards and audit committees. They recognise the importance of a high quality audit to their own business.

The appointment process is more transparent and heavily scrutinised than for most other professional services and companies are able to obtain what they require through the threat of tender. All of this results in a highly competitive audit market in which quality is high and prices are competitive.

As the changes over the past 10 years have shown, the audit market for FTSE350 companies is much more dynamic and competition for audits much fiercer than it would first appear. Above all capital markets are able to function effectively as a result of the trust that is created by the audit.

James Chalmers, Head of Assurance, gives his view on the provisional remedies announced by the Competition Commission.

View transcript

The Competition Commission have announced a significant package of proposed remedies. At PwC we think competition is critical. Transparency between the auditor, the audit committee and the shareholder is also paramount but perhaps most important is audit quality. I’ll highlight four of the proposed remedies.

Increased tendering = The Competition Commission proposes to increase the tendering period from once every 10 to once every five years.

They also propose increasing the frequency of regulatory reviews of audit quality in each of the FTSE 350 audits.

They are proposing a shareholder vote on the quality of the audit committee report and the disclosures in it and

Also they’re proposing to enhance the role of the audit committee in the audit process to where quite frankly best practice is today.

All of these remedies will create burdens for companies, for regulators and firms. So we are surprised that after only nine months of the new FRC 10 year tender regime, they’ve concluded that there’s a need to reduce the tendering period further when there is already so much market activity and response to the FRC proposals.

We’re going to look closely at the detail including cost benefit. We have long argued against mandatory rotation because of its adverse effects on competition. After careful and detailed consideration of the evidence, and listening to the concerns of the market, we’re pleased that the Competition Commission has arrived at the same conclusion.